Banking On The Blockchain by Morgan Stanley

Ever since Bitcoin was introduced in late 2008, the blockchain code that underpins the cryptocurrency has been the source of hope and fear—and much hype. In theory, agile startups could create software built on blockchain protocols with the hope of providing a safer, faster, cheaper and more transparent alternative to traditional financial intermediaries, such as banks, brokers and complex clearance processes. The opportunities, much of which is currently focused on post-trade processing, could compete with, and potentially threaten, financial incumbents.

In practice, incumbent financial institutions are investing in building permissioned blockchains—a digitally distributed ledger where authorized users can record, process and verify transactions—to streamline their own operations and costs, according to a recent Morgan Stanley Research report, “Global Insight: Blockchain in Banking: Disruptive Threat or Tool?” In short, Wall Street sees an opportunity to hack its own complexities using this new tool. Blockchain technology could help banks reduce the clutter and cost of numerous complex processes, say co-authors Huw van Steenis, head of European financial industry coverage, and Betsy Graseck, who covers U.S. Large Cap Banks. While broad-based adoption could take as long as a decade, exchanges, custodian and central depositories should see changes come quicker, in the next 12-18 months.

The practical applications of the blockchain will take time—as well as regulatory blessings and long-term industry adoption—but clients and investors could benefit significantly, as would the financial industry itself, via streamlined and less costly operations, as well as better products and services for customers.To deliver better efficiency and interface with other parts of the tech food chain seamlessly, an industry blockchain would have to be built simply and elegantly so that all parties can leverage and understand it.

The Consortium Route

The transition will likely be gradual. Expect blockchain applications to appear one asset class at a time, in an iterative process that may take as long as a decade. When change comes, it will likely come from industry consortia—not startups. “The market may underestimate the opening advantage for banks and custodians,” says Graseck. “If they can deliver a more streamlined process with lower costs, they will be a formidable competitor.”

Through consortiums, banks are now engaged in a broad range of proofs of concept. As winning ideas emerge, expect banks and related intermediaries to agree on common standards, with regulatory support, to share the expense of building a blockchain, whether it leverages their existing infrastructure or not. Two such partnerships, the Hyperledger Project and the R3 Blockchain Consortium, each have many proofs of concept underway, attracting participation from dozens of major institutions.

One of the most frequently discussed potential use cases for blockchain technology is post-trade settlement for a wide range of securities, including syndicated bank loans. Today’s process is costly, with each party relying on teams of people to review, authorize, verify and potentially dispute transactions. “Transacting parties using the same distributed ledger could have more visibility to help speed up resolution management, which should lower staff costs associated with post-trade settlement,” van Steenis says.

Cost/benefit: Blockchains could speed financial transactions, but faster isn’t always more profitable. Given the high cost of building a blockchain system, any proposed use must have a positive return on invested capital. “The question is, can incumbents achieve increased security, speed, transparency and efficiency using enhancements, blockchain or otherwise, to existing infrastructure,” Graseck says.

Cost mutualization: If a shared blockchain were to work like an interoperable industry utility, banks would need to share the cost of building the infrastructure. Making this equitable could be challenging, given banks’ wide variation in size and need for customization.

Aligning incentives: Not all parts of the financial food chain have the same incentives. Different entities may have conflicting priorities for a shared blockchain. But without large groups of users, blockchains wouldn’t be successful.

Evolving Standards: Users want to determine a standard ahead of any material investments. Too many choices could slow down adoption. Given their deeper pockets, larger competitors are in the forefront of driving the standard.

Scalability: Any blockchain must scale effectively from proof-of-concept to succeed, a key reason why most new blockchain proposals are looking at a range of rules, including ones that restrict users or centralize all, or part, of the blockchain. Without these, higher energy costs could eliminate the benefits from lower personnel costs.

Governance: A blockchain would need a governing body to decide who gets access to the blockchain and manages its maintenance.

Regulation: The familiar challenges of regulating digital identities and cross-border standards would have to be addressed during the build-out.

Legal risks: Users on a financial services blockchain must be identifiable entities, perhaps via something like a single digital passport number. Regulators would still enforce “know your customer” and anti-money laundering rules, regardless of the software protocol.

Security: Does the blockchain offer more resilience for security? Banks will have to perform extensive research to ensure that any blockchain they implement is at least as resilient as their current infrastructure against attack.

Simplicity: To deliver better efficiency and interface with other parts of the tech food chain seamlessly, an industry blockchain would have to be built simply and elegantly so that all parties can leverage and understand it.

These roadblocks, while not insurmountable, show why blockchain technology most likely won’t disrupt the financial industry as quickly or as completely as some expect. While financial institutions are investing in research now, adoption will be iterative, asset-class by asset-class over the next five to ten years, say van Steenis and Graseck. Even as the industry begins to adopt blockchain technology, institutions are likely to incorporate the new technology into existing systems with workarounds, instead of completely scrapping their current infrastructures for a brave new blockchain world.

For more Morgan Stanley Research on blockchain technology and its potential impact on the financial industry, ask your Morgan Stanley representative orFinancial Advisor for the full report, “Global Insight: Blockchain in Banking: Disruptive Threat or Tool?” (Apr 20, 2016). Plus, more Ideas.

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